If accounts are audited AO has to explain the rejection of profit with sufficient clarity. When there are audited accounts of an entity and the calculation of the GP ratios hinges upon their analysis, the AO should not lightly undertake an exercise that would amount to negating those accounts
ABCAUS Case Law Citation:
ABCAUS 2011 (2017) (07) HC
Assessment Year : 2006-07; 2007-08
Brief Facts of the Case:
The Respondent-Assessee was the Proprietor of two firms which were engaged in the manufacturing of cosmetic goods. For the relevant AY, the Assessing Officer (AO) assessed the total income of the Assessee at Rs. 1,47,00,040/- as against Rs.2,02,760 as declared by the assessee. The AO came to the conclusion that the gross profit (GP) of the units of the Assessee located at Himanchal Pradesh was abnormally high when compared to the GP of the units located in Delhi; these units were selling the products through another related concern of the family on consignment basis.
According to the AO, even after accounting for the advantages that accrued to the units at Himanchal, at the highest an average GP to the extent of 23% may be allowed instead of 38.05% as declared by the Assessee. Consequently, the net profit (NP) ratio for the deduction under Section 80 IC of the Income Tax Act, 1961 (‘Act’) was computed at 21% and a difference was added back to the income of the assessee. Likewise for AY 2007-08 the AO on similar basis, added back the difference in the GP by taking it at a maximum of 25% instead of 43.07%
On appeal by the assessee, CIT(A) allowed the appeals. The CIT(A) held that the AO was not justified in rejecting the trading results shown by the Assessee summarily without pointing out either any mistake/deficiency in the accounts or disturbing the figures of sales or purchase as declared by the Assessee. According to the CIT(A) there were considerable differences in the business environment of the Assessee’s concerns in Delhi and at H.P. Consequently, the CIT(A) was of the view that the AO was not correct in slashing the GP rates in both the areas and substituting it by that determined by the AO.
Aggrieved by the orders passed by the CIT(A) for both AYs, the Revenue went in appeal before the ITAT which dismissed the appeals. The ITAT concluded that the AO had arbitrarily made the addition by rejecting the books of accounts and the additions made by the AO were rightly deleted by the CIT(A).
The ITAT was of the view that the AO had invoked Section 80IC read with Section 80-IA (8) and (10) of the Act on the basis of conjectures and surmises only without having an iota of material on record justifying such action.
Observations made by the High Court:
The High Court noted that under Section 80-IA(8) of the Act, one of the pre-requisites for the AO to not grant the deduction as claimed by the Assessee in his return is where the AO finds that the consideration at which transfers were made of goods and services of the eligible business as recorded in its accounts does not correspond to the market values of such goods.”
Ït was further noted that the Proviso to Section 80- IA (8) further states:
“that where, in the opinion of the Assessing Officer, the computation of the profits and gains of the eligible business in the manner hereinbefore specified presents exceptional difficulties, the Assessing Officer may compute such profits and gains on such reasonable basis as he may deem fit.” (emphasis supplied).
The High Court observed that the expression “such reasonable basis” pre-supposes that the AO has to explain with sufficient clarity why the AO is rejecting the profit figures as put forth by the Assessee which emerges from the audited accounts of the Assessee. In the present case, for instance, the AO had to explain why he was rejecting for AY 2006-07 the GP ratio of 38.05% and substituting it with a rate of 23%. The AO rejected the explanation given by an Assessee as to the difference in the selling price of the products manufactured by it at its Himachal unit compared to that at Delhi unit. The AO proceeded merely on the basis that the sales were to related parties thus giving an unfair advantage to the Assessee.
The High Court observed that without pointing out the error, if any, in the accounts or disturbing the figures of sales or purchases, to compare the trading results of business of two units and simply rejection was clearly not a “reasonable basis”, as contemplated by the proviso to Section 80-IA (8) of the Act. The AO’s order did not explain the basis for determining the GP ratio of 23% instead of 38.05% for AY 2006-07 and 25% instead of 43.07% for AY 2007-08.
It was held that In the circumstances, the ITAT’s conclusion that the AO’s order was passed on conjectures and surmises could not be said to be erroneous. ITAT did not err in holding that invocation of Section 145 of the Act in the facts of this case was not justified and the order of the ITAT in its interpretation of Section 80-IA (8) and (10) of the Act is not erroneous.